Friday, 24 July 2015

Macro - Ominous Decade

"Fascism is capitalism in decay." - Vladimir Lenin
Following Greek's submission and the acceptance by French Constitutional court of the controversial surveillance law aimed at broadening eavesdropping of terrorism suspects, despite protests from privacy advocates with France seeing at the same time a "farming revolt", in conjunction with Spain's new public security law introduced in July limiting freedom of speech and curbing the right to peacefully protest with the introduction of fines ranging between €100 ($111) and €600,000, we reminded ourselves of the "Ominous Decade" (Década Ominosa) when it came to choosing this week's analogy. 

The "Ominous Decade" was the traditional term used for the last 10 years of the reign of King Ferdinand VII of Spain dating from the abolition of the Spanish Constitution of 1812, from the 1st of October 1823 to his death on the 29th of September 1833. Following the liberation of Spain from Napoleonic domination, King Ferdinand VII first act on his return was the dissolution of the two chambers of the Spanish Parliament which marked the period of the "Ominous Decade" which saw harsh censorship re-established and the complete suppression of the liberal opposition (which fled the country). This "Ominous Decade" saw an endless series of riots and attempts of "revolutions", such as that of Torrijos, funded by English liberals on the 11th of December 1831. Given the turn taken by recent events in Europe and with European Commission president Jean-Claude Juncker quote in February this year: 
"There can be no democratic choice against the European treaties." - Jean-Claude Juncker
We are indeed wondering if, Europe has not entered its own "Ominous Decade" hence our chosen title. 

We are also wondering if, after all, Vladimir Lenin's quote was not correct, and we could opine in the light of recent laws passed in various countries that indeed, Joseph Schumpeter seminal 1942 book "Capitalism, Socialism and Democracy" was indeed right when assuming that the decay in capitalism is indeed somewhat leading to some new form of "fascism". Schumpeter argued that capitalism's collapse from within will come about as majorities vote for the creation of a welfare state and place restrictions upon entrepreneurship that will burden and eventually destroy the capitalist structure but we ramble again...

When it comes to forward returns and current valuations levels and the "rosy tainted" environment painted by some sell-side pundits, in this week's conversation we will discuss into further details the return of the deflationary forces (hence our recent return in taking a long US duration exposure partly via ETF ZROZ) and "Zemblanity", (Zemblanity being defined as the inexorable discovery of what we don't want to know). Back in September 2012 we asked ourselves at the time the following question:
"Does the end (lowering unemployment levels) justify the means (increasing M) or do the means justify the end (deflationary bust)?" - Macronomics, September 2012.
  • Some "Zemblanity" facts in the transportation market
  • Forget Greece, China is sending a weak global growth message
  • If China is stalling then it makes sense to "short" exposed European car makers 
  • Final chart: Credit and Equities parting ways

  • Some "Zemblanity" facts in the transportation market
For those who have been following our musings, you will not be surprised that we view the transportation market, particularly shipping as a leading deflationary indicator as well as a credit indicator (lower shipping = credit tightening = deflationary trend). When it comes to the "real economy" and "Ominous Decade" risk, in true "Zemblanity" fashion, transportation is telling us that the much vaunted recovery story remains illusive and marks the return of the deflationary forces we think.

On that point we agree with Bank of America Merrill Lynch's take from their Cause and Effect note from the 13th of July entitled "Who do you believe?":
"Some inconvenient facts
The transportation market, which is more closely linked to the world economy, does not share this optimism. Global shipping freight rates, down 40% so far this year, are showing no signs of recovery. Our latest trucking survey shows sentiment at the year-low. Rail traffic remains very weak and rail stocks are down nearly 20% year to-date.
The million dollar question is whether what appears to be increasing growth optimism among rates investors is justified. The transportation market, which is much more closely linked to the global economy, apparently does not think so:
Global container freight rates, which have been falling this year, are showing few signs of stabilization, let alone recovery. The bellwether China export containerized freight index is down 40% so far this year (Chart 7) and is now below the trough associated with the height of the Eurozone crisis in 2012:
Falling freight rates seem to reflect more weak demand than excess capacity. World trade volume growth, which in Q1 contracted at the fastest pace since the end of the financial crisis, recovered weakly in April (Chart 8).

Inbound loaded containers into the Port of Los Angeles and Long Beach, having surged in March following the end of the strike, was down in April and flat in May (Chart 9).
Trucking is also faring poorly. The latest BofA Merrill Lynch proprietary biweekly Truck Shipper Survey shows shippers’ 3 month outlook falling below 60 for only the second time in 2015 (Truck Shipper Survey #78, 9 July). An increasing number of the respondents are citing weak demand.

If shipping and trucking are not doing well, rail is not doing much better. US rail traffic for intermodal units, which picked up in the spring after the end of the port strikes, is slowing again (Chart 10). 

Meanwhile, total carloads are contracting at an annualized rate of 10%. US rail stocks, already down 18% year-to-date, continue to underperform the broader index (Chart 11).
In sum, what the transportation market is telling us is that global trade growth is weak. This is consistent with the fact that in the June manufacturing PMI surveys released last week, new export orders were either declining or below 50 for most of the major economies (Chart 12). 

If global trade in manufactured goods is weak, it seems reasonable to think that global manufacturing is weak. Indeed, the new orders component of world manufacturing PMI has fallen in June to the lowest level in two years (Chart 13).
 - source Bank of America Merrill Lynch
To illustrate further the "illusory" recovery in 2015 we would like to add additional data, this time around coming from Deutsche Bank Freight Tracker note from the 21st of July. Truck Supply/Demand in 2015 is in fact weaker in 2015 than in 2014:
"Below we have illustrated the recent trends in TL dry van load-to-truck ratios (Figure 4 below) as well as dry van spot rates (Figure 5 below) in each of the past two years based on TransCore data.
 - source Deutsche Bank

If the economy is improving in 2015 compared to 2014, which would justify a "normalization" policy from the Fed, then we struggle in understanding the "dynamic" improvements so much vaunted by the "recovery" pundits...

This is leading us to our second point, namely that one should indeed focus less on Greece (a sideshow) but much more on the weaker global growth signs coming out of China.

  • Forget Greece, China is sending a weak global growth message
Whereas the Greek soap opera has been gathering much of all the attention in recent weeks, the global growth seems to be heading like the proverbial bull in a China store. The preliminary PMI from Caixin Media and Markit Economics was at 48.2 for July from 49.4 the previous month, the lowest in 15 months, regardless of China's "engineered" 7% GDP growth.

Once again, shipping is leading us to some interesting indications when it comes to gauging the strength of the Chinese economy and the trajectory for world growth. If we look at the Shanghai-US Container Rates Overview from Deutsche Bank Freight Tracker note, one can clearly acknowledge the weaker tone in Chinese exports:
"SCFI spot rates declined 10.9% w/w as rates continued to fall across the board."

- source Deutsche Bank
Whereas we are talking West Coast Ports or East Coast Ports, the year on year change points to a clear weaker tone in exports towards the United States.

What we find of interest is the recent fall in consumer confidence which we think is indicative of the fragility of this much vaunted "recovery".  For instance, Consumer confidence in July dropped four points month-over-month to 45.2%, a low for 2015 but still higher than the 13 month low reported back in October (41.0%). But, "Confidence" among Small Business Owners is off as well at 53.8% (from 55.0% in June) which doesn't look great from an "employment" perspective.

As we pointed out in our 15th of August conversation "The link between consumer spending, housing , credit and shipping":
"Containerized traffic is dominated by the shipment of consumer products. A resurgence in international container volumes will be dependent on the housing markets improving. Furniture and appliances are some of the top freight categories imported into the U.S. and euro zone from Asia in containers. Furniture demand collapsed with the housing market." - source Bloomberg
The link between freight shipments and changes in housing start can be seen in the below graph coming from Deutsche Bank's most recent Freight Tracker report:
"Cass Freight Shipment Index Declines 3.4% Y/Y In June (+0.2% M/M). Last week, Cass Information Systems reported that the Cass Freight Shipment Index declined 3.4% y/y in June, which was an acceleration from down 1.3% y/y in May. Sequentially, the index was essentially flat (+0.2% m/m), which was worse than normal seasonality (June’s trailing five- and ten-year average m/m changes are up 1.8% and up 2.4%, respectively)."
 - source Deutsche Bank
Whereas housing starts have jumped in the U.S. in June to the second-highest level since November 2007 to  9.8 percent to a 1.17 million annualized rate from a revised 1.07 million in May, consumer confidence and shipping are yet to reflect this improvement so far. This is indeed depicting a conflicting picture when it comes to US growth particularly with the lack of acceleration in wages.

Moving back to China, not only does shipping and PMI points towards a slowdown but so does credit growth and passenger vehicle sales year on year as shown by Bank of America Merrill Lynch in their Cause and Effect note from the 13th of July entitled "Who do you believe?"
"The transfer of wealth from the people on the street to the wealthy who cashed out when the market was still going up is likely to hurt consumption. It is important to take note of the fact that in June, before the equity correction began, passenger vehicle sales fell for the first time since 2012 (Chart 16)."
It seems reasonable to think that a further moderation of Chinese growth will have global repercussions. On a Purchasing Power Parity basis, China is now the largest economy in the world, accounting for 16% of global GDP. More importantly, the IMF estimates that China accounted for one third of global GDP growth over the past three years (Chart 17).
A sharp Chinese slowdown in H2 (not the central scenario of our China economics team) would easily send world GDP growth to the lowest level since the recovery began.
That said, the impact of a Chinese slowdown on the rest of the world will be uneven. Countries like Korea and Australia whose exports to China account for a large share of their GDP will be especially vulnerable (Chart 18). 

Even Japan and Germany that have significant exposures to China will not be able to escape the implications of a sustained Chinese slowdown.
What about the US? US export exposure to China is modest, both in absolute and in relative terms. However, long-term Treasury yields have been more correlated with global growth outlook than US growth outlook over the past few years (Chart 19).
Moreover, further USD appreciation as other countries would be hurt more by the Chinese slowdown, by tightening US financial conditions, is likely to lead the Fed to go more slowly in the tightening cycle. The first batch of June data suggests that the momentum behind the US economy observed in late spring seems to be slowing. Aggregate payrolls in Q2 grew at the lowest rate in six quarters (Chart 20)."
- source Bank of America Merrill Lynch
 So if indeed China is slowing, then it makes sense to look at "shorting" the European Autos Sector (SXAP). This brings us to our third point namely never ending overoptimism from equity analysts...

  • If China is stalling then it makes sense to short exposed European car makers 
If you buy into the story of an "Ominous Decade" and poor forward returns thanks to lofty valuations, Chinese slowdown and waning global demand (hence like us, sitting nicely in the "deflationary" camp), then we believe, it makes sense to look at over-exposed European car makers and to make a case for a "short" perspective we think.

On the subject of "deceleration" and cars in China, we read with interest Société Générale's note on Automobile and Components from the 15th of July:
"We see a margin issue in the Chinese premium car market: The market is crowded, not only on the roadway, where the number of premium cars has been growing fast, but also by the number of carmakers, who long for share in this formerly high-margin market. The “German big three” has 70-80% of the market, and the remainder is divided up among the Europeans, Japanese and Americans. Since H2 2014, these carmakers have started to see volume pressure owing to the economy’s slowdown, competition from local rivals, limits on car registrations in big cities, and pressure from a legitimized parallel premium car market. Official price cutting took place but turned out to be ineffective. Margin pressure was further aggravated by the rally in the A-share market in May that absorbed money from people who had delayed their car purchases. Despite these headwinds, we still see potential in the Chinese premium car market based on a growing middle class population because although the economy is slowing, the growth rate is still relatively high. Indeed, China’s economy historically has grown in the double-digits, but the market is now expected to experience a structural transition period where automobile financing (still low less than 20% in China vs. 50% in developed countries which reserves room for development) and electric cars (strong support from the government due to environmental concerns) could be a new growth impetus." - source Société Générale
While we agree from a long term perspective, there is further room for growth in the Chinese car market, the on-going pressure on the market is of particular interest as highlighted in Société Génerale's note:
"Premium carmakers have been forced to step into a tough price war since H2 2014, against the backdrop of China’s economic slowdown. Given the choice between market share and margins, carmakers chose to sacrifice margins temporarily in order to win and keep market share. Tier 1 premium brands have started to lower prices or decrease production in China. Audi is selling its two popular models, the A4L and A6L, at a 20-25% discount. BMW China’s CEO said that the group had already decreased its production in China as well as the supply to dealers (Source: Bloomberg 20 April). Going into the second quarter of 2015, new car sales have continued to shrink. The situation got even worse with the euphoria in the A-share market which absorbed the car budgets from a large number of people who were holding back on buying big-ticket items.
In our view, the other factors that are prompting a slowdown in premium car sales growth include but are not limited to: limits on new car registrations in big cities, pressure from a legitimized parallel car market, competition from local car brands, the government’s antiextravagance policies, consumption behaviour transformation (more mature customers) in the tier1 and tier 2 cities, an explosive second-hand car trade volume (9m units in 2014, over 10m expected in 2015), and a technology-driven growth model, which can be summarized as the Chinese automotive market’s “New Normal”.
In order to maintain margins and market share, we expect carmakers to cut costs, which
passes on pricing pressure to upstream auto parts makers and raw material providers. Thus, we believe the “German Big Three”, accounting for 70-80% of the premium car market, will leverage their negotiating power to lower production costs and save margins.
We expect a moderate premium car sales expansion in 2015, with a growth rate slightly higher than our forecasted 8% of passenger vehicle sales growth rate. The China Automobile Association forecasts that in 2015, the volume of sedans will increase slightly by 1% to 12.5m, SUVs will increase by 25% to 5.1m, MPVs will increase by 35% to 2.6m, and crossovers will decrease by 20% to 1.1m, which together represent passenger vehicle sales of 21.2m units and a 7.8% growth rate.
We expect three trends in the Chinese premium car market in 2015
1) The import growth rate to slow to the single-digits when premium carmakers focus on localisation: the high tax rate imposed on imported cars is one reason for customers’ move to localised cars, especially against the backdrop of the economic slowdown and customers’ high cost/performance preference. We expect more import models to be localised in the coming year.
2) SUVs to continue to be popular: the Chinese prefer large-sized cars and have a tendency to favour popular models, thus we expect premium carmakers to take action and make profits in this segment with new localised models." - source Société Générale
So the only way for the German Big Three to maintain further their margin will be to either force more deflationary pressure on their suppliers impacting furthermore the "commodity" sector in the process or to localize even more the production of cars in China to lessen the high tax rate imposed in imported cars which have been impacted by the bloodbath in the A-share market as of late.

What goes up must come down:
As per the conclusion of our "Ephedrine" conversation focusing on China in May this year, where we pointed out correctly that Dr Copper, the metal with the economics Ph.D was still in a bear market, we believe that European car makers in particular the German Big Three will soon have to adapt to the "new normal". This is clearly illustrated in Société Générale's note:
"The market for premium cars in China has expanded at an impressive rate of 36% per year over the past decade. Multinationals dominate China’s premium car market, with German carmakers accounting for 70-80% of market share.
Premium segment development is part of the change in passenger vehicle sales. From 2000 to 2010, the average passenger vehicle sales growth rate was 24%, and from 2010 to 2014, the growth rate slowed to 7%, which indicates that China’s automotive industry has stepped into a new growth period." - source Société Générale
The "goldilocks" period for the German Big Three, from a "short" perspective, seems to us an attractive proposal given their significant exposure to China. On that "short" interest, we agree with Louis Capital Markets recent take on this "trade idea" in their recent Cross Asset Strategy note from the 15th of July:
"The European Autos sector (SXAP) is fully driven by the German carmakers as Daimler, Volkswagen and BMW make more than 50% of the sector index. These global companies have a significant exposure to non-European markets and particularly, to China. The chart below shows the amazing increase of the profitability of the European Autos sector since the great crisis.
Despite a sluggish European economic environment, these European companies have benefited from their global exposure to record all-time high profits. In relative terms (below chart) the diagnosis is even more impressive and this explains why this sector has been a strong market leader since 2009.
The sector has been weak recently (2nd worst performer behind basic resources over the past 3 months). This is an interesting message as the profit dynamic seems intact. The direct consequence is that analysts have seen the recent correction as a buying opportunity given their unchanged earnings forecasts over the period. According to them, nothing has changed except the upside potential that is restored thanks to the decline of share prices. This differs from banks on which analysts remain cautious and do not expect a significant share price recovery.
We do not wish to treat analysts with disdain but there is clearly a risk that, once again, their expectations fall short of the reality. We do not see the latest correction as another opportunity but rather we see this correction as a warning for the sector similar to what banks experienced in the summer 2007.
The story of the Autos sector during the past decade looks like a “super cycle” and because we believe in cycles (i.e. ups and downs) we suspect that the nicest part of the story is far behind us and that difficulties can arise faster than expected.
We are beginning to see less positive stories coming from China regarding the Autos sector (price discount to revive sales, subsidies to affiliates) but these less positive aspects seem to have gone largely unnoticed by market commentators. It is typical to see some denial at the early stage of a new trend. The charts below shows the strong fundamentals of the “big three” – the 3 biggest components of the SXAP Autos sector – that have enjoyed a super-cycle over the past 5 years (average sales growth of 11.7% against average of 2.6% during the 2002-2007 cycle).

Also, perhaps the most impressive achievement is to see the structural improvement of margins since 2009. On the below chart we plot on the Y-axis the quarterly EBIT margin and on the X-axis the quarterly sales growth for the Big3. The blue dots represent the 2002-2008 cycle whilst the grey dots represent the 2010-21015 cycle. The message is crystal-clear here: despite some volatility of the business activity, the EBIT margin has remained resilient around 7%. This is a real performance that was flagged by analysts and this could explain why some investors play the “change of status of the sector” due to its new “growth status” (luxury goods + pricing power).

Its a nice story but too good to be true in our opinion and reminds us of our discussion with Banks’ analysts back in 2007 (see our European Equity Note No241 – 25 June 2007 – “The Valuation Principle”, CA Cheuvreux) when we told them that the specific risk premium that was emerging on financial stocks was worrying and that these stocks were expensive. We want to say the same thing today: despite apparent low valuation ratios, European carmakers are expensive because profits should revert soon and will reveal therefore that the profit trend growth of these companies is lower than expected.
We show on the following chart Global car sales growth and that of the Big 3. Obviously the correlation is strong between the two series but we see the significant outperformance of these winners in the aftermath of the Great crisis thanks to their Chinese exposure and their above-average pricing power.
However, talking about the past will not help us in forecasting the market behaviour of these names in the coming weeks so the latest data are more interesting and they show a very significant slowdown of the sales dynamic. In China, June was a negative month, for the first time since 2013. The 3-month moving average is at 0.5%, the lowest level since Q1 2012 which was at that moment only temporary.
We think that the current weakness will not be transitory and reflects the start of the down cycle for the European car makers exposed to China. The rationale is simple: generating growth is a tough task as for a carmaker it implies selling more cars each year. The strong growth rate achieved by the European carmakers in China was the result of the concurrency of several factors: low base effect (low starting equipment rate), strong growth of income and strong growth of the potential client base (emergence of the middle class). Today these factors have not disappeared but have strongly diminished. The number of cars in use compared to the size of the urban middle/upper class in China is no longer extreme. The catch-up process from this point of view is over and now, the demand for cars should be driven by more classic factors like the vehicle age (implicitly the average life expectancy of cars) and the size of the middle class.
In the short term, the excesses have to be clear and this implies a decline in units sold in China by the European leaders of the car industry. Thus, the investment risk is very high for the Big 3 as investors are not ready for this outcome. They will be reluctant to sell them because of some sentiment towards stocks that have done so well in their portfolios in this cycle. We understand that but investors have to set aside “affect” and be pragmatic as downs follow ups and China will not be an exception." - source Louis Capital Markets
Of course from a long term perspective China and Asia will continue to be important drivers for European car makers but, we do have to agree with LCM's tactical view on this interesting "short" contrarian proposal, which we think is enticing.

China, it’s still a critical driver of German carmakers’ earnings and the current trend is quite disturbing, therefore we think shorting the German Big Three from a valuation perspective could be an interesting proposal should China worries persist.

German exports and Chinese PMI are still showing a disconnect which we think is not justified. Car sales in Europe during the first six months of 2015 are down 14% compared with the same period in 2007. In Germany, car sales are up by only 3% in the same period whereas Italy is down by a cool 38% and Spain is down 35% back to 90s levels (for more on cars sales and trends see our 21st of April conversation "The European Clunker - European car sales, a clear indicator of deflation").
So even the mighty German can't really look West to find some Chinese solace...

Does a Chinese slowdown spell an "Ominous Decade" for German car makers? We wonder...

  • Final chart: Credit and Equities parting ways
Whereas in 2014 the much vaunted story of  the "Great Rotation" from "Bonds3 to "Equities" failed to materialize, in 2015 it seems indeed there has been some rotation at least in European towards equities as depicted by Bank of America Merrill Lynch in their Follow The Flow note from the 17th of July entitled "June'15 Flows: biggest outflow for fixed income funds since the tape tantrum":
"Credit and equities: parting ways
Flows remain on the negative side for both high-grade and high-yield funds, despite strong risk-on sentiment. Outflows from high-grade credit funds were the third largest this year, at $2.1bn, and ~$10bn has departed from the asset class in the past six weeks. Outflows from high-yield credit funds were marginal, however, marking the sixth consecutive week of withdrawals from the asset class.
On the other side of the fixed income world, government bond funds followed an opposite course from credit: the asset class recorded an inflow of +$1.4bn during the last week, the first in seven weeks and the highest in 18 weeks, dating back to the pre-bundshock period. Money market fund flows went back to negative territory.
But the picture is different in the equity land. European equity funds have seen inflows doubling that of the previous week, getting very close to $3bn. Equities have now had a nine week streak of positive inflows, against six weeks of consecutive outflows from high-grade and high-yield credit funds combined.
 - source Bank of America Merrill Lynch
"Where wealth accumulates, men decay." - Oliver Goldsmith, Irish poet

Stay tuned!

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